Capital Gains Tax

Any profit earned from the sale of a capital asset is considered a capital gain. The profit earned falls under the category of income. As a result, a tax must be paid on the income earned. The tax is known as capital gains tax, and it can be either long or short term.

Long-term capital gain tax: Long-term capital gain tax is a tax on earnings made from the sale of an asset held for longer than a year. Long-term capital gains are normally taxed at a lower rate than short-term capital gains.
The rationale behind the lower tax rate for long-term capital gains is to encourage individuals to store assets for longer periods of time, which can stimulate long-term investment and economic growth. Individuals may be more eager to hang onto their assets instead of selling them fast for a profit if the tax rate on long-term profits is reduced. Long-term capital gains tax rates for 2022 and 2023 are 0%, 15%, or 20% of earnings, depending on the filer’s income. The income levels are modified on an annual basis.

Short-term capital gain tax: Short-term capital gain tax is a tax on earnings made from the sale of an asset held for one year or less. Short-term capital gains are often taxed at a higher rate than long-term capital gains, which are gains on assets held for more than a year. The rationale behind a higher tax rate on short-term capital gains is to deter people from indulging in short-term speculation and instead encourage long-term investment. Individuals may be less likely to engage in quick purchasing and selling of assets for a profit if they face a larger tax burden if short-term gains are taxed at a higher rate.

Advantages of Capital Gains Tax

Capital gain tax is a tax on gains made from the sale of an asset that has increased in value. The purpose of this tax is to create revenue for the government while also promoting justice in the tax system. Here are a few of the main reasons why capital gains tax is advantageous:

1. Revenue generation: To support public goods and services like infrastructure, education, and healthcare, the government must produce revenue. Taxation is one of the key means by which governments generate money, and capital gains tax is one such source of revenue.
2. Encourages long-term investment: Capital gain tax rates are normally lower for assets that have been kept for a longer length of time. This tax policy is intended to encourage individuals to keep assets for extended periods of time, encouraging long-term investment and economic growth.
3. Promoting equity: The capital gains tax is intended to ensure that people who make money from investments pay their fair share of taxes. Those who earn income from investments would pay less tax than those who get income from salaries and wages if capital gains tax were eliminated.
4. Tax evasion prevention: Capital gains tax serves to reduce tax evasion by requiring individuals to accurately declare all their capital gains. Individuals may under-report their gains to avoid paying taxes if there is no capital gains tax.

Disadvantages of Capital Gains Tax

1. Discourage investment: High capital gain tax rates may deter individuals from investing because they will face a hefty tax burden when they sell their assets. If the tax rate is high, the projected return on an investment may be reduced, making it less appealing to investors. High capital gain tax rates may deter investors from selling their assets in particular instances, reducing market liquidity and efficiency.
2. Reduce market liquidity: Capital gains taxation has the potential to limit market liquidity since high tax rates may dissuade investors from selling their assets. When investors incur a large tax burden when selling an item, they may choose to keep it instead, decreasing the amount of assets on the market for purchase. This decrease in supply has the potential to undermine market liquidity and efficiency, perhaps resulting in price distortions and greater volatility.
3. It is complex and difficult to understand capital gains tax can be difficult to understand and calculate, especially for those with several investments and income sources. Capital gains are taxed differently depending on several circumstances, including the length of time the asset was held, the type of asset, the taxpayer’s income level, and the taxpayer’s tax bracket. Individuals may also need to keep track of the original purchase price of the asset and any revisions to that, such as for asset improvements. Failure to assess the capital gain or loss on an asset appropriately might result in tax underpayment or overpayment.
4. Capital gain tax policies can have unforeseen implications, such as encouraging people to keep assets for too long or to make riskier investments to balance tax responsibilities. Individuals, for example, may be tempted to keep assets for longer periods of time to benefit from reduced tax rates on long-term capital gains. While this may encourage long-term investment and stability, it may also result in inefficient resource allocation and decreased market liquidity. Individuals may also be incentivized to undertake riskier investments to offset tax responsibilities, such as investing in assets with high potential returns but also high hazards. This might cause higher market volatility and expose investors to significant losses.

Recent changes and their impact

• To make the long-term capital gains tax structure more relevant, the finance ministry is considering establishing parity between similar asset classes and changing the base year for computing indexation advantage. Currently, shares held for more than a year are subject to a 10% tax on long-term capital gains. Gains from the sale of immovable property and unlisted shares held for more than two years, as well as debt instruments and jewels held for more than three years, are subject to a 20% long-term capital gains tax. The ministry currently considering rationalizing tax rates as well as the holding period for computing long-term capital gains. These changes were likely to be taken place in the budget of this year but no changes were undertaken.
• As per experts, various changes were made to the capital gain structure after 2004, which has become too complicated to understand due to different rates and time frames for various classes of assets and investment methods such as equity, debts, mutual funds (viz. growth oriented, daily dividend, debt/equity oriented), land & buildings, foreign shares, and so on. To simplify, the assets class can be divided into two limbs: movable assets and immovable assets, with a single timeline on the period of holding to consider gain/loss either short term or long term.
• Finance Minister Nirmala Sitharaman declared a Rs 10 crore ceiling for long-term capital gain tax exemption in the Union Budget 2023. The new limit will take effect on April 1, 2023. Sections 54 and 54F of the Income Tax Act mandate a deduction for investing in residential buildings.
• The Lok Sabha approved the Financial Bill 2023 on March 24, 2023, with over 45 modifications. Capital gains from debt mutual funds will now be considered short-term capital gains, which is a big development.
  According to the Budget 2023 revisions, there would be no indexation benefit in the computation of long-term capital gains on debt mutual funds beginning April 1, 2023. Debt funds with less than 35% invested in equity would now be taxed at the income tax bracket and classified as short-term capital gains. Bank fixed deposits are taxed in the same way.
• Indexation Benefits: Indexation benefit refers to the inflation adjustment applied to an asset’s cost basis, which is used to determine capital gains tax liability when the asset is sold. The indexation benefit’s goal is to account for the effects of inflation on the value of the asset over time so that the capital gains tax reflects the asset’s genuine rise in value. This effectively lowers the amount of capital gains that would be taxed.